Macro Forces

"The lesson that I have learned is that it isn't reasonable to be agnostic about the big picture."

-David Einhorn

There was an article in the Wall Street Journal on Friday that was forwarded to me hundreds of times over. The article was titled “Macro Forces In Market Confound Stock Pickers.” There was nothing particularly new in the article. Everyone who has protected their client’s hard earned capital in the last 3 years gets that macro matters. But what about those who don’t get it? What’s their answer to David Einhorn’s mental flexibility? Do their answers matter?

Macro Forces certainly matter. As Risk Managers, it’s our job to both identify their market impact and proactively prepare for their most “improbable” outcomes. I have a great deal of respect for someone like Einhorn because he can skate circles around Captain Stock Picker out there but, at the same time, acknowledge that he needs to continually evolve his investment process to incorporate the macro frontier.

If you are a bloodhound who trades merger arbitrage or your job is to be long of the next stock to hit this market’s broadening “rumor mill” of takeout targets, that’s fine. Maybe you don’t do macro until, as Mike Tyson would say, it “punches you in the face.” For the rest of us, “it isn’t reasonable to be agnostic” about global macro market risk anymore. October 1987 mattered.

Being Duration Agnostic is also something we evangelize a lot here in New Haven. My sense is that the Buy-And-Hope model of yesteryear isn’t going to be emailed to me 100 times over via a WSJ article anytime soon. Legacy print media has a funny way of being a lagging indicator. All that said, we need to focus intensely on compartmentalizing calendar catalysts that are macro in nature. It’s unreasonable to actively manage risk otherwise.

During Friday’s US stock market short squeeze I was also getting a lot of emails asking me when I was going to short the SP500 (SPY). After 3 consecutive down days (Tuesday, Wednesday, and Thursday), the illiquidity rally was broad based and I think the questions were well timed.

Unfortunately, I’m not enough of a cowboy anymore to stand on the other side of this market’s intermediate term TREND line and call it anything other than what it became on Friday – what was 1144 resistance in the SP500 is now support.

It’s not my job to be bearish or bullish. It’s really not my job to be anything other than a student of whatever it is that Mr. Macro Market throws at me each and every day. There certainly were more bearish than bullish fundamental research data points in my notebook last week but at the end of the week they were all trumped by Mr. Macro’s market price. The US Dollar has been demolished (down 14 of the last 17 weeks) and the reflation trade is back on.

To be crystal clear, there are no rules in this game suggesting that the 1144 line cannot become resistance again. The Macro calendar of catalysts for the early part of this week that could easily be construed as bearish are:

Monday: A breakdown close through 1144 on the SP500 combined with a failure of the VIX to breakdown through its critical 20.77 line of support.

Tuesday: A reminder that Housing Headwinds remain in the US economy with the Case Shiller report for July.

Wednesday: An acknowledgement by both Japan (Tankan Survey) and the US (Obama speaks on joblessness) that Fiat Republics are not stable.

Then, of course, you have month and quarter-end on Thursday for the hedge fund business on top of a Chinese PMI report for September that could go either way. No one said that doing macro is easy. The way we all get paid in this business, it shouldn’t be…

The Macro Forces that are bullish out there are fairly straight forward at this point:

Prices: The SP500 is up +9.43% for September-to-date!

M&A: Unilever buys Alberto Culver this morning for $3.7B making at least 1 of the 67 rumors of takeouts we are tracking true…

Mid Terms: If you didn’t know the Republicans are going to take the House, now you know.

“Republican House” being on the cover of Barron’s this weekend certainly doesn’t make this a new Macro Force to consider. That’s why we did our risk management call with Karl Rove last month to get ahead of this. As always, the better questions in our risk management lives surround what people aren’t talking about. These factors, too, need to be considered on a Duration Agnostic basis.

Whether or not the intermediate term TREND line in the SP500 of 1144 holds or not definitely matters to me in the immediate term. At the same time, out on the long term TAIL, the biggest question is why won’t the US stock market continue to make a series of lower-long-term-highs like the Nikkei in Japan has?

There are only 7 countries in the world who have underperformed Japanese equities for the YTD at this point (in order of worst to Japan: Greece, China, Slovakia, Italy, Portugal, Spain, and Ireland). Sadly, in response to another lower-long-term-high in the Nikkei, this morning the Japanese have introduced another 4.6 TRILLION Yen in stimulus. Shame on those who don’t learn history’s lessons. They deserve to lose.

My immediate term support and resistance lines for the SP500 are now 1131 and 1150, respectively.

Best of luck out there this week,

KM

Keith R. McCulloughChief Executive Officer

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09/27/10 07:22 AM EDT

THE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - September 27, 2010

As we look at today’s set up for the S&P 500, the range is 19 points or -1.54% downside to 1131 and 0.12% upside to 1150. Equity futures are trading lower as European market struggle for direction with some support coming from M&A activity in the Food & Beverages sector. Gold continues to re-test the $1300 mark. Today's macro highlights include: Chicago Fed.

Allergan (AGN) got FDA approval for Ozurdex drug

In Barron’s - Best Buy (BBY) may gain as much as 30% in the next year as it increases sales with new products.

SECTOR PERFORMANCE: XLI was the best performing sector on Friday buoyed by a better than expected Durable Goods report; notables in the sector - CAT’s +4.6%. Financials, consumer discretionary, materials, energy and tech were all up over 2%. Technology and Telecom were laggards.

EURO: 1.3492 +1.02% - up 6.22% over the past two weeks and 3 of the last 4 weeks

DOLLAR: 79.395 -0.77% - Down 4.03% last two weeks and 13 of the last 16 weeks

OVERSEAS MARKETS:

Europe

European markets are trading modestly higher in reaction to Friday's gains seen on the USA and in a follow through to a strong session in Asia.

M&A continues to dominate news flow in the absence of any regional macro releases.

Irish banking concerns are set to continue ahead of announcements due sometime this week on the cost of the bailout for Anglo Irish Bank.

Food & Beverages, Oil & Gas and Travel sectors are pacing advancers.

Asia

Asian markets followed Wall Street up today.

Commodities-linked firms rose on higher metals prices.

Australia enjoyed a broad rally powered by banks and miners.

LNGrose 1% after saying it is studying the possibility of a new liquefied natural gas project in Queensland;

Japan rose, but consumer lenders plunged on reports that Takefuji, which was suspended, had ¥433.6B in liabilities as of 30-Jun and is preparing to file for bankruptcy. Advancers led decliners almost 3-to-1.

NKE: Back to the Future(s)

Guess what folks? Futures matter again. The 14% growth # is completely consistent with our call on a multi-year business acceleration. But let’s not turn a blind eye to the math. Weighted channel growth is 3% -- 4% tops. This 10% from share gain NEEDS to continue with the stock up here. (Note: if images are not coming through -- let us know and we can send out the raw analysis).

Despite being a big bull for reasons that I still think other bulls don’t appreciate, I noted last week that those looking to manage risk around the quarter at least needed to acknowledge the sky-high expectations on both sides of the Street. In other words, ‘at least play it safe and take out your umbrella if there’s rain in the forecast.’

So what did Nike do? They ‘pulled a Nike’ and toasted the high-end of expectations. If there’s any one notable takeaway after packaging up all the commentary, Q&A and financials, it’s that the financial and human resource pain trade inside of Nike a year and a half ago is starting to pay off. Global demand is reaccelerating; a) in both footwear AND apparel, and b) across all the company’s new consumer categories. This has legs, folks. See our Nike Black Book from earlier this year for more details.

That said, the quarter was less than perfect, and there are a few items that raise question marks. These might seem like nit picks, but when the stock trades up after expectations were already so high, we need to nit pick.

a) The quality of the beat ($1.14 vs. our $1.08 and the Street’s buck) was not outstanding. Revenue missed our model by 2-points and the Street’s by a point. Blame it on FX – as the business remains solid on a constant-currency basis – but FX is KNOWN, so there should not be any surprises there.

b) Gross margins looked solid – right in line with our model and above NKE’s sandbag.

c) But the big delta was in SG&A, where operating overhead was flat on a -4.8% comp last year.

d) So the bottom line is that revenue delta cost $0.02 relative to our $1.08, and an unsustainable SG&A rate added up for $0.08. So overall…sales were +8%, EBIT was +11% and EPS was +10% (higher tax rate offset repo).

e) Sales/inventory spread and SIGMA position are good, but eroded 1,000 basis points sequentially. Not a disaster, but notable.

Back to the Future(s)

That brings me to the title of this note. Friday morning Keith and I were discussing the numbers. I took a few minutes and gave the plusses and minuses of the financials – noting the low quality relative to expectations. Then I got to the 14% North American futures number, and he looked at me like I had two heads and chuckled. He was probably thinking something like “Hello! Anybody home McFly? Think McFly, Think!”

That’s when it hit me… Sell side analysts and people inside the company – of which I was both – have it engrained in them that ‘futures really don’t matter that much anymore.’ That, of course, is a product of a time period where NKE would trade on the US business and nothing else. Even when US Footwear got to be less than 1/3 of sales – the US footwear number is what would drive the stock, and would drive the company (and the sell side) batty. Over the past few years, the market finally ‘got it’ that there’s more to this business than the US. But today, Mr. Market is definitely reverting to his former view as to what’s important. The trader in Keith got this in about 3 seconds flat. It took my inner McFly a couple hours to get ‘Back to the Futures’.

NOTE: Though unrelated, Nike secured a patent last quarter for a self-inflating shoe. Remind you of anything?

That leads to the 14% NA futures number. Let’s put things into perspective. 14% growth over the next 2 quarters is the equivalent of adding $289mm in new business (assuming that 85% of the base is on the Futures program). This number annualized is bigger than the ENTIRE US BUSINESS for over 90% of the footwear brands in the world. The good news is that the number is balanced over footwear and apparel. That definitely makes this number more easily digestible.

But is anyone watching the comp, square footage growth, and inventory trends of the channels that sell Nike’s product? Yes, they’ve picked up recently – no doubt. They’re also generally light on inventory. And yes, a better R&D cycle should help as well. But keep in mind that Adi and Reebok are no longer share donors (after losing 11 points of share—from 18% to 7% -- over 5 years) and casual brands like Skechers are giving it a go in the performance category.

Precise quantification of this order number is tough. But here’s our best crack. When we add up comp and square footage growth by customer and by channel, we get to about $128m top line growth for the YEAR – or about 2.5%. Now…this excludes growth in Nike retail and Nike.com – both of which should take the aggregate growth rate on a reported basis for Nike up by another 2-3 points. So what we need is to justify doubling this growth rate again due to market share gains in order to get to 14%.

*Hedgeye Estimates

Right now, this is absolutely, positively, 100% realistic. But with Nike’s sales/inventory spread ticking down on the margin, and sales in the channel (incl square footage) supporting 3% growth, we need to sustain a steep trajectory in share gains to keep the halo on the US futures number.

It pains me to even write this, because our long-term call is so much bigger than the US. But Mr. Market just told us that local share matters again. We’re going to have to keep our Hedgeyes on this into the fall.

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EARLY LOOK: Don't Eat Yellow Snow

“Even if you are on the right track, you will get run over if you just sit there.”

-Will Rogers

Oklahoma’s favorite son, Will Rogers, probably didn’t know it at the time but he made a very important contribution to modern day risk management with the aforementioned quote.

Rogers was our kind of guy. Multi-factor, multi-duration, and not afraid to put his thoughts out there for everyone to criticize every day. He was transparent and didn’t feel compelled to live a professional life of opacity. He lived his life out loud.

By the time he passed away in 1935, Will Rogers penned more than 4,000 nationally syndicated newspaper columns and produced 71 movies. He also traveled across the world 3 times. This gave him a unique perspective on the interconnectedness of human behavior.

The most important thing we can acknowledge about human behavior when we buy or sell something is that we are human. By nature, we are more likely to think something we own is worth more than it’s worth. Ultimately, the market’s last sale decides the price.

Another critical acknowledgment in modern day risk management is that the game is changing at a rate that’s representative of global economic imbalances, fund flows, and geopolitical risks. Never before has the US government sponsored so much market volatility. Never before has the hegemony of US economic power been such a question mark. Never is a long time.

My son Jack is barely 3 years old, but as winter approaches he will be old enough to learn his first few rules in risk management. Never eat yellow snow, and never trust a professional politician.

Whoever chooses to trust Greek, Irish, or US politicians who are telling us that they’ll never have to default on any long term liability because they have figured out how to print short term debt-upon-debt-upon-debt subscribes to a belief that the history of sovereign debt cycles doesn’t support.

If you choose to trust what you see, recognizing this globally interconnected game of risk is always “risk on”, you are most likely going to see this Fear of Government trading environment plainly. You don’t have to “just sit there” and suck it up. You can keep moving.

There are two ways that I’ve applied this basic strategy of motion to express my investment views:

I don’t run a hedge fund anymore. So far, this is the best I can do to communicate what it is that I am trying to recommend you do out there. I know that other people don’t do it this way. I also know that I’ll need to keep changing what it is that I do or I’ll get “run over.”

Back to explaining what it is that I’ve been doing this week…

1. Dynamic Asset Allocation to CASH:

On Tuesday when I “Walked The Line” (title of Early Look note that morning) and the SP500 was testing a breakout above my intermediate term TREND line of 1144, I moved to 64% CASH = selling strength.

On Thursday, after the SP500 closed down for the 3rd day in a row, I reinvested 6% of that CASH position into Commodities (DBA) and German Equities (EWG), taking my CASH position down to 58% = buying weakness.

Naturally, some “fully invested” asset managers are going to look at this and say a few things:

You can’t hold a cash position like that.

You can’t time markets like that.

You can’t …

But, yes I can.

Rather than just sit here and accept that at any given moment in my day the government can either squeeze me or displease me, for now I’m going to keep moving with an explicitly large amount of cash on the sidelines to deploy whenever I see the opportunity to do so.

My immediate term support and resistance levels for the SP500 are now 1113 and 1143, respectively.

THE WEEK AHEAD

The Economic Data calendar for the week of the 27th of September through the 1st of October is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

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09/24/10 03:42 PM EDT

RESTAURANTS – DOES INFLATION MATTER?

Over the past number of quarters, top line numbers have taken precedence over food cost trends in determining investor sentiment. With food costs continuing to increase, when are investors going to shift their focus?

Looking at the restaurant space, it is difficult to know which factors are driving the space. The health of the consumer, commodity costs, and government policy are all important and interconnected. As I outlined on 9/20 in a post titled, “NO MORE ROOM AT THE TROUGH”, regulatory action has been a cause of food inflation and remains a potential cause today. With the topline results of many restaurants remaining robust, it seems that any investor concerns on inflation are assuaged by same-store sales growth. It is only when the tide goes out that the rocks beneath the water line can be seen.

The narratives that we can spin around current stock moves are legion. Perhaps consumers are defaulting on their debt and splurging on discretionary items. Perhaps the prospect of more quantitative easing, and lower mortgage rates to refinance to, are boosting spending. Or perhaps we are burning brightly just before we plunge into a dark depression. Rather than bother with these anecdotal hypotheses, we prefer to look at some data. The chart below shows clearly that some restaurant and agriculture stocks have been performing strongly of late, with several exceptions (particularly the agriculture stocks).

Many of these price moves are confirmed by top line trends. CMG and MCD have been outperformers from a sales perspective, while EAT and WEN have been softer on that same metric. Looking at the possibility that commodity costs have played any role in these recent price moves, it is instructive to observe the agriculture stocks’ price action. I will allow readers to decide for themselves, but one thing that stands out to me is that Monsanto (MON) is a beneficiary of higher corn prices but has been underperforming. Given a number of factors alluded to in the aforementioned note from 9/20 (Dollar down=corn up, ethanol blend in gasoline, strong demand), we believe that corn prices are set to move higher with the inverse relationship with the US Dollar being our main focus. While TSN, CAG, and SAFM have been going down, as one would expect, MON would be expected to perform strongly with high corn prices. See the table below for some correlation data (stock to corn).

Due to contracts or other hedging mechanisms, the impact of higher commodity costs may be somewhat staggered versus price performance in the restaurant space but it seems that CMG, BWLD, YUM, CBRL, and CAKE stand out as being impervious to commodity cost increases. We know that BWLD has outlined lower year-over-year chicken wing prices as being earnings accretive over the next few quarters but other largely uncontracted (CMG) stocks are also unimpeded, thus far, by the threat of rising costs.

At Hedgeye we are currently short the US dollar and have a very bearish view for the intermediate term. As the table above suggests, this stance implies a bullish view on corn prices. When planning for the next fiscal year, many companies begin to lock in their commodity needs late in Q3 and early Q4. I was surprised earlier this week to learn that DRI management have left themselves exposed to certain commodities given the recent spike in commodities. Management believes that current levels of some commodities the company uses are unsustainable. I am not sure I would be so confident. The table above outlines the correlation between the USD and certain commodities.

Howard Penney

Managing Director

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